Between the Ears: 5 Psychological Mistakes that Many Investors Make

Shrewd investors are aware — if not outright hyper-vigilant — of external clues that suggest whether they should seize an opportunity or run for cover. But what happens when their own brain and emotions steer them in the wrong direction? That’s when things get costly; and in some cases, catastrophic.

Here five psychological mistakes that many investors make, which end up steering them on the rocky and scary path to financial regret instead of the (relatively) smooth and empowering road to financial success:

  1. Anchoring

Anchoring happens when investors have blind faith in their knowledge about a stock, a company, a trend, or anything else. This unwillingness to acknowledge and process new information often leads to bad decisions that seem wise at the time, but in hindsight are revealed to be staggeringly flawed.

  1. Recency Bias

Recency bias is a kind of anchoring that focuses on recent information. For example, investors fall in love with company, a sector, an index — and so on — based on reading or hearing positive news in the last few months, but neglect to dig deeper and discover issues and facts that would at the very least take (as the poets say) some of the “rose off the bloom” and compel them to proceed with caution; or in some cases, end their love altogether.

  1. Confirmation Bias

Confirmation bias happens when investors filter out information that doesn’t align with what they believe to be true. This belief can be positive or negative. For example, an investor may have stock in a company that is rumored to be having financial troubles, and there is speculation that it may file for bankruptcy. As a result, the investor plans on dumping his stock to cut losses. A few days later, the investor comes across new, credible information that a successful VC firm is in talks to fill the financial shortfall, and boost capital reserves by millions of dollars to support future growth. However, due to confirmation bias, the investor doesn’t change their stock dumping plan — even though doing so would have generated significant gains and avoided huge losses.

  1. Loss Aversion

Loss aversion refers to a psychological process in which the fear of losing something — e.g. the value of an investment — is more intensely perceived and experienced, than is the pleasure of gaining something. For example, many elderly investors are so petrified of losing their principal, that they park their life savings in bank or credit union savings accounts that pay very little interest that is below the rate of inflation. Even when these people are made aware that their cash is losing its purchasing power, they refuse to change their approach because the fear of loss is more compelling than the happy anticipation of gains.

  1. Sunk Costs

Sunk costs might be the most difficult psychological trap to avoid — but also arguably the costliest. It happens when investors refuse to sell a losing investment, because they are focusing on how much they paid months, years or even decades ago. Unfortunately, what they initially paid (or may have paid over a period of time) is largely irrelevant. What matters is how things are now, and how they are expected to develop in the future.

Here is an example of how dangerous sunk costs can be in the business world: a large organization that spent $150,000 on a conventional phone system several years ago refuses to switch to a hosted VoIP phone system now — not because they would save thousands of dollars per year and access a range of advanced features like giving every employee their own VoIP number (what is a VoIP number? Find out in the link), but because they can’t look beyond the money they spent. They are stuck in the past vs. focusing on the present and future, and paying a very steep price for their lack of vision.

The Bottom Line

Will avoiding all of these psychological risks and traps turn ordinary retail investors into the next Warren Buffet? Of course not. However, being aware of them — and steering clear of them — will definitely increase the odds of more wins, and fewer losses. And in the big picture, that’s what really matters.